Banks need to prepare now for Covid-19 losses later

The writer is a banking consultant at Veritum Partners

The Cape of Good Hope is the point where the Atlantic and Indian oceans meet, creating treacherous seas that have claimed the lives of many sailors. A similarly gargantuan battle is playing out today across the world’s economies, as plunges in economic activity never seen before are being met by extraordinary government support. And, just as at the Cape, the outcome is unpredictable.

The uncertainty is perhaps most clearly seen in the wide range of estimates that banks around the world are using for future losses. In the first quarter, the five largest US banks booked $25bn of expected losses for soured loans, compared with just $11bn for Europe’s five largest, on loan books of similar sizes. Some of the variation reflects different accounting rules. But even within Europe, where they must all use the same accounting, the differences were still enormous.

When the banks start reporting second-quarter results next week, investors should watch closely to see if this divergence narrows and why.

Different views on the future drive some of these variations, reflecting the economic uncertainty. In estimating its first-quarter loan losses, Barclays assumed a base-case decline in UK gross domestic product of 8 per cent, while Lloyds Banking Group assumed a decline of just 5 per cent. This wide range of outcomes is understandable; the future is always uncertain, and never more so than today.

However, regulators are also driving divergent estimates of future losses. This is far less justifiable and may be setting Europe up to repeat mistakes made after the 2008 financial crisis. Specifically, the European Central Bank is actively encouraging its lenders to go easy on taking provisions against potential soured loans by offering guidance on how aspects of the accounting rules should be interpreted more sympathetically. In March it said it would give banks flexibility in the treatment of loans and that banks should “avoid excessive procyclical effects”.

In the first quarter, some EU banks appeared to have followed that encouragement to avoid booking large provisions, while others have not. It is particularly notable that often those with lower capital ratios — and therefore smaller cushions against losses — appear to have booked smaller provisions, while those with more capital took bigger hits. Spain’s Bankinter — with a ratio of core tier one capital to risk-weighted assets of just above 11 per cent — booked losses representing only 0.4 per cent of its loans, whereas HSBC — boasting an equivalent capital ratio approaching 15 per cent — built in losses of $3bn, equivalent to 1.2 per cent of its loan book.

We have seen this kind of divergence before. After the 2008 financial crisis, US banks set aside more money, more quickly, for bad loans compared with those in Europe. Capital markets rewarded them with stock market valuations that recovered faster and more completely than those in Europe. By contrast, many European banks adopted an “extend and pretend” approach, and even before coronavirus were still suffering depressed valuations.

But the real damage of the less aggressive European approach can be found in the continent’s subdued economic growth over the period since 2008. Many commentators, including the OECD, ascribe that to Europe’s weakened banks’ inability to lend. Indeed, entering this current crisis many — especially those in southern Europe — were still saddled with levels of non-performing loans of up to 10 per cent of their loan book, 10 times the US level.

Absent the sharpest of V-shaped recoveries, Europe’s banks will at some point need to recognise the new economic reality and raise their provisions for loan losses dramatically. The forthcoming results season may provide just such an opportunity.

Rather than warning European banks against recognising losses, regulators should be encouraging them to recognise as many as they can while maintaining their ability to provide funding to the economy.

Banks have capital buffers for just such occasions, and today the level of capital across European banks is overall considerably higher than required by regulators. Clearly, some would struggle to recognise larger loan losses, but the industry should not again be constrained by the capacity of the weakest players.

Otherwise, Europe risks repeating the same mistakes as a decade ago and entering the post-coronavirus world with weaker banks saddled with higher levels of bad loans and still failing to regain the trust of global investors.